16 minute read 7 Nov. 2019
Boat heading towards a storm

Banking Results FY19

By Tim Dring

EY Oceania Banking & Capital Markets Leader

Provides value through deep financial services experience with a point of view. Husband and father of three and enjoys playing golf and following AFL and cricket.

16 minute read 7 Nov. 2019

    Cash Earnings (total of all four major banks)

    $26.9 bn

    Decrease of 7.8% (total of all four major banks)

    Net Interest Margin

    1.94 %

    decrease of 9 basis points

    Return on equity

    10.9 %

    Decrease of 125 basis points

    Cost to income

    49.7 %

    Increase to 3.1%

    Remediation costs

    $5.7 bn

    Pre-tax

    Note:

    Figures throughout this report are calculated on the prior corresponding period unless otherwise stated. 

    ANZ, NAB and Westpac’s full year reporting periods ended on 30 September 2019. CBA’s full year reporting period ended on 30 June 2019.

    Unless otherwise specified, references to ‘the banks’ and ‘the major banks’ in this publication refer to the ‘big four’ Australian banks: ANZ, CBA, NAB and Westpac.

    It has been a challenging year for the banks. Aggregate cash profits again declined, falling 7.8% driven by:

    • Net interest margin (NIM) compression due to the intense competition from smaller ADIs and non-banks, ongoing shift to lower margin products and impact of cash rate cuts.
    • Growth constraints in the critical home loan segment under pressure from tighter verification requirements and falling house prices.
    • Elevated risk and compliance investment needs, and additional provisions for remediation.

    The banks’ average cash return on equity (RoE) continued its downward trend, driven by lower earnings and higher capital requirements. Margin and cost management remain high priorities, as options to improve profitability are constrained by the emerging ultra-low interest rate environment and the heightened demands of regulatory compliance. For now, asset quality remains generally sound, but benign credit conditions will not continue indefinitely and, when the credit cycle turns, that will squeeze the banks’ profits. Further regulatory capital changes may affect banks’ capital strategies, including dividend policies.

    At the same time, a slowing growth outlook for the Australian economy may prompt new monetary policy measures and additional stimulus initiatives. Uncertainty in global markets, driven by global trade tensions, remains a key risk to a sustained pickup in activity.

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    Revenues

    A number of headwinds have dragged on overall revenue

    Over the year, aggregate statutory net interest income was relatively flat on the back of lower NIM and weakened growth in housing. Product performance issues also played a role in falling revenues, with products failing to perform as designed due to system and operational errors. For example, some mortgages failed to convert to principal and interest payments after the interest only period expired or failed to convert to a higher interest rate once the introductory period expired.

    Net interest margin (NIM)

    Average NIM fell by 9 bps compared with 12 months ago, driven largely by intense price competition from non-major banks and other ADIs, and from non-banks that leveraged a growing securitisation market.

    Switching trends also contributed to NIM contraction, as borrowers continued to switch from higher margin loans (interest only, investor and variable rate) to lower margin loans (principal and interest, owner occupier and fixed rate). For some banks, customer remediation of overpaid interest had a negative impact.

    To sustain margins, the major banks did not pass on rate cuts in full to borrowers, despite the intense scrutiny on mortgage pricing by the government and regulators. While earlier mortgage repricing helped to offset the impact of cash rate cuts in June and July, the declining cash rate will see ongoing pressure on NIM in 2020 as recently announced home loan repricing flows through. This may be offset in part by renewed growth in higher risk-lending. For example, investor lending is showing signs of increased activity, with additional focus on ‘pricing for risk’.

    Pricing on the front versus the back book is under scrutiny, with banks under pressure to close the gap. The government has directed the ACCC to investigate the banks on their failure to pass on in full official rate cuts, which is likely to increase pressure on the banks to pass on any further rate cuts in full. Banks have benefited from higher margins in the back book, while offering heavy discounts for new borrowers. Profitability will face further compression if the gap narrows or closes. 

    Source: EY Analysis

    Funding Costs

    On the liability side, deposit and wholesale funding costs remain accommodative and should continue to support NIM in the short term. Easing short-term and long-term wholesale funding costs have given the banks welcome relief from margin pressure, with spreads reaching their lowest levels in several years.

    Deposit margins have also improved, with deposit rates following the cash rate lower. At the same time, deposit growth has picked up since June, particularly in household deposits. This may reflect the impact of the Low and Middle Income Tax Offset and the three cuts to interest rates.

    Part of the reason the banks are not passing on rate cuts in full is their lack of room to move on deposits. Although average deposit rates have fallen, a significant proportion of the banks’ deposits are at, or close to, zero interest rates. This means the banks cannot offset the impact of lower interest rates on mortgage lending by reducing the rates offered on deposits.

    Since the financial crisis, funding for lending has increasingly relied on customer deposits. Deposits now account for around two-thirds of the banks’ non-equity funding, with around half sourced from retail deposits[1]. However, faced with near-zero interest rates, this funding base could be at risk. Banks will need to manage deposit spreads carefully to control this risk as the deposit margin squeeze continues, driven by reductions on high interest savings accounts.

    Pricing decisions highlight the constant battle confronting the banks to balance the competing interests of depositors, borrowers and shareholders. Banks need to ensure prudential stability while also:

    • Making a sustainable level of return to support shareholder investment – because bank profits are a major contributor to superannuation fund returns and retirement savings
    • Maintaining their debt rating – because, otherwise, higher wholesale funding costs that will be passed on to borrowers

    But banks are also under pressure to support depositors by providing a good level of return on deposits, and borrowers by passing on interest rate cuts. In the constraints of the current operating environment, not everyone can be a winner.  

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    Credit Growth

    Has been subdued over the year

    Housing credit growth remained subdued over the year, on the back of changes to lending standards (expense verification, revisions to HEM benchmark calculations and expanded Comprehensive Credit Reporting) and weakened demand. System growth for housing credit fell from 5.2% to 3.1% over the 12 months to September 2019[2]. For the major banks, growth continued to slow in both owner occupier and investor loans, with lower housing prices and concern over the macroeconomic outlook dampening demand. Declining market share and margin pressure as interest rates fall suggest the major banks will struggle to grow housing credit in the next year.

    However, the housing market is showing signs of a turnaround, with increased loan applications and approvals in recent months. Housing finance has jumped 7.7% over the past two months, largely led by owner-occupier loans. Investor lending has also jumped by 10%, likely spurred on by recent rate cuts and certainty over property tax concessions.

    Housing loan growth: owner occupiers and investors (6 month annualised)

    Source: APRA, EY analysis[3]

    The improvement may also have been supported by APRA’s changes to the interest rate floor for loan serviceability, particularly in the owner-occupier segment. The banks announced new floor rates around 1.5-2% lower than the previous guidance of a 7% floor, with a minimum 2.5% buffer. Easing the interest rate floor has increased maximum loan sizes available to low-risk buyers. However, the impact on credit growth has not been significant as most borrowers don’t take out the maximum loan available to them.

    Interest rate cuts have been a key factor in lifting auction clearance rates and stabilising house prices, which in the past three months rose 2.2% on a national level, with gains of 3.5% and 3.4% in Sydney and Melbourne. Although house prices are still lower than 2016 levels, a “V” shaped recovery remains unlikely. Right now, the volume of new homes for sales remains relatively low. But, as we move to the end of the year, supply is likely to lift, capping further price rises. As a result, a modest lift in prices over 2020 is the most likely trajectory.

    A rapid housing price recovery will also be dampened by the declining confidence of off-plan apartment buyers in Sydney and, to a lesser extent, Melbourne. In 2019, the value of off-plan apartments in Sydney and Melbourne declined by 15% and 11%, respectively[4].

    The decline in personal credit lending has also accelerated. System growth fell 4.4% over the year to September 2019, compared to a fall of 1.4% over the previous 12 months[5]. According to APRA data, personal credit card balances fell 5.5% (6% for the major banks) over the six months to September 2019[6]. This may partly reflect disruption in the consumer loans market, as buy-now-pay-later services grow in popularity, prompting one smaller bank to halt plans for a strategic push into credit cards. It may also indicate that consumers are using tax refunds and mortgage savings from interest rate cuts to pay down household debt.

    Further disruption is likely with the rollout of open banking, which will empower consumers to switch financial institutions more easily and find deals that better meet their needs.  

    For the major banks, aggregate business lending increased, although results varied across individual banks. Across the wider banking sector, lending to large corporates grew around 5% over the year and continues to drive business credit growth, while lending to small businesses remained relatively flat. Small business lending growth has been affected by:

    • Tighter lending standards – with banks treating the division between personal and small business finances with more caution.
    • Housing price declines reducing the amount small businesses can borrow – as loans are often secured against residential property.

    Source: APRA [8]

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    Australian Economic Outlook

    Is mixed with subdued consumer confidence, low wage growth and heightened global uncertainty weighing on a slowing economy

    After a prolonged period of above average economic growth, the upward trend flattened significantly in the first half of 2019. Growth is currently running well below that required to boost inflation and reduce unemployment. In per capita terms, the story is stark, with the economy growing through population alone, not productivity nor participation. Australia ended 2018 in a per capita recession, after two consecutive quarters of negative per capita growth in Q3 and Q4 2018. Today, per capita GDP is 0.2% lower than it was a year ago. At issue is our constrained domestic household sector, with households experiencing soft income growth and low savings rates, and feeling burdened by the cost of living and the combination of high levels of debt and falling house prices. Unemployment is sitting at 5.2%, significantly higher than 4.5% - the RBA’s target for full employment - and underemployment is at 8.3%. There is spare capacity in the labour market and this will continue to limit wage growth.

    For the moment, heightened global uncertainty has not hit the Australian trade position. However, slowing global growth and rising protectionism is particularly problematic for Australia as a small, open economy, and this is likely to be reflected in our trade balance longer term.

    In the coming year, the outlook for the Australian economy is mixed. In recent months, households have benefited from a range of stimuli, including the Low and Middle Income Tax Offset, as well as three 25bp interest rate cuts – putting cash back into the pockets of a third of Australian home owners with a mortgage and those most likely to spend it. Yet consumer sentiment continues to fall. The big question is: Will people spend or save? The answer will have a significant impact on economic growth over the short to medium term.

    The business outlook is uncertain. In Q2 2019, mining profits lifted 10.9%; however, non-mining business investment disappointed and non-mining profits were flat. Meanwhile, concerns over the ongoing global trade tensions means business conditions and confidence are both running below long-term averages. All indicators suggest that a significant pick up in business investment is unlikely in the near term.

    The Australian economy is likely to need unconventional monetary policy support to achieve full employment and 2-3% inflation. The banks are preparing for the possibility that the Reserve Bank may start focusing on quantitative easing and forward guidance, which arguably is already occurring. We also anticipate additional fiscal stimuli will be required, with increased spending on infrastructure, further tax relief for consumers, and policies to reduce red tape and encourage investment. However, the government remains committed to delivering a budget surplus in FY20. This will limit options for additional fiscal spending in the year ahead.

    Costs

    The banks continue to manage underlying operating costs well, which generally declined or were flat in FY2019 for most of the banks. However, the combination of slowing revenues, higher remediation-related costs and increased investment in risk and compliance functions has seen cost-to-income ratios rise.

    Source: EY Analysis

    The banks have already driven down costs by divesting non-core businesses, streamlining and automating processes, simplifying business models and digitising their operations. But now they are under renewed pressure to further reduce costs to offset the impact of the slowing growth outlook. And they must do so while increasing their investment and technology spend to upgrade risk and compliance functions in response to regulatory changes – such as financial crimes compliance, the Comprehensive Credit Reporting regime, the Banking Code of Practice and open banking.

    Given the significant costs of upgrading risk and compliance functions, the Majors have been sidelining other digital transformation investment projects to manage upward pressure on cost-to-income ratios.

    In further bad news for cost reduction efforts, remediation costs continued to rise sharply, crimping earnings. For the 2019 year, the banks recorded or announced a further $5.7bn (before tax) in remediation costs for poor customer outcomes and regulatory non-compliance. Remediation costs announced since 2017 now total in excess of $8bn for the major banks. The further challenge is converting provisions for remediation back into cash in the hands of the consumers in a prompt and efficient manner.

    In the coming year, addressing remediation will require a huge investment of money and time by the banks, requiring an uplift in risk and compliance staff. It is a complex, multi-faceted issue that involves lengthy and costly investigation processes to reach an appropriate settlement outcome with customers. Potential for further top ups remains, in response to changing dynamics such as consumer credit insurance emerging as a potentially greater risk than anticipated. This suggests the banks will be dealing with the impost of remediation efforts for some time to come.  

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    Asset Quality

    Remains generally sound, though signs of deterioration persist

    Although asset quality remained generally sound, signs of deterioration persist:

    • Loans in arrears continued to increase (albeit off a low base), reflecting the impact of low wage growth and higher living costs. Household pressure was in evidence, with repeated cycles of households falling into arrears, then bringing payments up to date before the loan became delinquent. That said, the recent reductions in interest rates should ease pressure on households. Plus, many households are ahead on their repayments.
    • Bad and doubtful debt charges rose 13.5%, but remained low by historical standards.
    • Collective provisioning (both short and long term) increased markedly. This largely reflects the transition to AASB9, with the value of certain types of collateral declining and the majors having to attribute lower internal credit ratings to customers. This has moved pools of loans into higher provisioning rates.

    Other areas of potential exposure include residential property construction firms, retailers of discretionary goods and those affected by the drought in the eastern states.  

    In a sign of the times, to optimise revenues in the face of a narrowing range of options to boost the bottom line, banks began investing in collection processes for the first time in nearly a decade.

    Source: EY Analysis

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    Capital

    The major banks are well capitalised but changes to regulatory capital requirements and profitability pressures may see the banks adjusting their capital strategies

    CET1 ratios across the banks are currently all well above APRA’s benchmark of 10.5%. However, changes to regulatory capital requirements and profitability pressures may see the banks adjusting their capital management strategies to ensure capital ratios are sustained at the ‘unquestionably strong’ level. The question mark over the full extent of potential remediation costs also remains a risk.

    Regulatory capital changes

    Changes to capital requirements announced during the year are likely to impact the banks’ capital management programs.

    Under APRA’s recently announced framework for loss-absorbing capacity, the banks are required to increase their total capital ratios by 3% by 2024. This will align them with their global peers given capital framework differences. The banks have issued $12bn of Tier 2 instruments in recent months but will need additional funding.

    Over 2018 and 2019, APRA also imposed capital overlays on the banks for poor operational risk management practices. The banks are currently required to hold an aggregate total of $2.5 billion in capital add-ons to reflect higher operational risk. The overlay for each bank will remain in place until the weaknesses have been fully remediated.

    Higher capital requirements to be introduced by the Reserve Bank of New Zealand (RBNZ) will affect the New Zealand subsidiaries of the Australian major banks. With the RBNZ’s capital requirement changes due to be finalised in November, the banks will be reassessing group dividends and potential future buy-backs to ensure sufficient equity in their New Zealand entities to meet these new requirements. It may also prompt some of the banks to reduce their exposure to New Zealand over the coming years. APRA’s recent proposal to increase the amount of equity required by the banks to support investments in large subsidiaries could further influence the banks’ future strategies for their New Zealand businesses. 

    Proposed revisions to the capital framework to better align capital and risk are intended to be ‘capital neutral’ and should not require additional capital raisings by the banks. The reforms are intended to reduce the banks’ balance sheet concentration on residential mortgages, by increasing the average risk weights for housing loans compared with other asset classes. For example, risk weights on investor or interest only mortgages will increase relative to those for owner-occupier principal and interest mortgages.

    Dividends

    The challenging operating environment and changes to regulatory capital requirements are also pushing the banks to review their dividend policies. Dividend payout ratios have remained at 75-89% of earnings over the last four financial years, reducing the major banks’ ability to invest in the future.  If the Reserve Bank cuts the cash rate further or undertakes alternative monetary policy measures, such as quantitative easing, dividends will likely need to be cut over the next two years. 

    Source: EY Analysis

    RoE

    Lower cash earnings, higher capital requirements and customer remediation costs continue to place downward pressure on RoE. From returns in the high teens pre-financial crisis, average RoE for the banks has steadily trended down and now sits at at 10.9%.  With ongoing growth pressures and an ultra-low rate environment, banks may need to revise target ROEs downwards.

     

    Source: EY Analysis

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    Rebuilding trust

    The banks are working hard to rebuild trust. Winners will be those who systemically incorporate non-financial performance and risk.

    Bank performance is no longer simply about financial results, but also about rebuilding trust. APRA's Information Paper on issues in banks’ culture and risk governance highlighted some common themes brought out by the Royal Commission: under-developed frameworks for managing non-financial risks; lack of accountability for such risks; lengthy period of time to resolve deficiencies; and insufficient understanding of own risk culture to support the Board[9].

    In the last year, the banks have accelerated their efforts to enhance accountability and improve risk cultures. Many still need to determine what ’good’ performance looks like and to hardwire customer centricity into the way they work. Winners will be those who systemically incorporate non-financial performance and risk. This will require investment in defining, measuring, tracking and reporting on non-financial performance and risk, including linking performance outcomes to remuneration and long-term incentives.

    How boards respond will be key to re-build trust and confidence in the sector. Boards must take ownership for non-financial risks, including reputation, brand, sustainable performance and innovation. To assure good customer outcomes, boards will need to measure and monitor culture and customer outcomes and use consequence management to enforce accountability.

    What does the future hold?

    The seismic shift in consumer preferences, economic trends and regulations means the banks have tough choices ahead to determine how they stay relevant, earn customer trust and position themselves for success in the next five years. With the fast-approaching introduction of open banking, the future will usher in changes that will fundamentally shift the landscape and business models of financial services firms. In an ecosystem where incumbents are being challenged by new digital-only banks, payment service providers and technology firms, the banks must act now with bold purpose and a clear focus on improving margins, lowering costs and managing shareholder expectations.

    We believe the time has come for the financial services industry to fundamentally reframe itself. And that reframing process should begin now, with a shift to strategies that build trust, ensure the financial health of customers and offer bundled offerings that move away from selling products to present more holistic and personalised value propositions.

    To find out where EY sees the financial services industry now, next and beyond and how we are helping our clients achieve their future vision, explore our  NextWave Consumer Financial Services video and report.   

    • References

      [1] Bulletin: Developments in banks’ funding costs and lending rates, Reserve Bank of Australia, March 2019, https://www.rba.gov.au/publications/bulletin/2019/mar/pdf/developments-in-banks-funding-costs-and-lending-rates.pdf

      [2] Financial aggregates: September 2019, Reserve Bank of Australia, https://www.rba.gov.au/statistics/frequency/fin-agg/2019/fin-agg-0919.html

      [3] Majors include ANZ, CBA, NAB and Westpac; Other ADI includes all other ADIs (including foreign banks) but excludes non-banks

      [4] CoreLogic August 2019 data

      [5] Financial aggregates: September 2019, Reserve Bank of Australia, https://www.rba.gov.au/statistics/frequency/fin-agg/2019/fin-agg-0919.html

      [6] Monthly authorised deposit-taking institution statistics, APRA, https://www.apra.gov.au/monthly-authorised-deposit-taking-institution-statistics

      [7] Financial Stability Review, Reserve Bank of Australia, October 2019, https://www.rba.gov.au/publications/fsr/2019/oct/pdf/financial-stability-review-2019-10.pdf

      [8] Includes all ADIs (including mutuals)

      [9] Information paper: Self-assessments of governance, accountability and culture, APRA, https://www.apra.gov.au/sites/default/files/information_paper_self-assessment_of_governance_accountability_and_culture.pdf, 22 May 2019

    Summary

    In a challenging environment, with global and local headwinds, rebuilding trust needs to remain at the forefront for the major banks.

    About this article

    By Tim Dring

    EY Oceania Banking & Capital Markets Leader

    Provides value through deep financial services experience with a point of view. Husband and father of three and enjoys playing golf and following AFL and cricket.